Regulation of Systemically Important Financial Institutions

Lauren Bennett

Abstract

The financial crisis of 2007-8, precipitated by the collapse of the international bank Lehman Brothers, had serious global repercussions. As a result, the international community turned its attention towards the largest and most powerful global financial institutions, whose collapse would have the potential to lead to another global recession. The regulation of such establishments, formally referred to as Global Systemically Important Financial Institutions (G-SIFIs), has therefore become increasingly important as global governance bodies attempt to both reduce the likelihood of institutional collapse and limit the adverse affects of such failures on the international economy.

The implementation of resolution regimes has been occurring at a slow pace and compliance with such measures has been limited. Thus, regulators need to work towards more developing a proactive supervision framework that is able to keep up with the increasingly complex international financial network. At present there is no global regulator, and action therefore requires national attention and coordination. Thus, the national government of the country in which the institution is situated is considered responsible for disciplining the body and minimizing the effect of its failures on the international economy. The inconsistency of this approach in the past demonstrates the limits of global regulation, and arguably, the need for a more global approach.

Introduction

As a result of globalization, the worldwide economy has become increasingly interconnected. Despite this, the global recession exposed the failure of policymakers and financial institutions to prepare for the possibility of financial contagion. Hence, economic analysts, regulators and international governments were caught off guard with the onset of the financial crisis in 2007. To restore faith in the markets and protect other banks from suffering the same fate as Lehman Brothers, (which suffered the largest bankruptcy in US history), national governments intervened and public bail-outs were arranged for several institutions, including Fannie Mae and AIG.

Thereafter, discussion at global summits centered on how to avoid the recurrence of such economic hardship in the future. It was agreed that higher standards, as recommended by advisory regulatory bodies, needed to be enforced at a national level. Hence, the categorization “global systemically important financial institution” (G-SIFI) was created to describe those powerful institutions whose activities required greater supervision. Explanation of what this increased scrutiny means for these businesses will follow, along with discussion of why resolution regimes are important, and a comparison of the successes and problems that regulators have experienced.

What makes an institution a global SIFI?

The Financial Stability Board (FSB) distinguishes a global SIFI as an institution whose disruption or failure would demonstrate a significant obstacle in the smooth running of the international financial system and the activity that takes places within it due to its great “size, complexity and systematic interconnectedness” (Financial Stability Board 2011). Such companies are also described as “too big to fail,” because liquidating these institutions is viewed as “too disruptive and costly to society” (Strub 2012). Consequently, intervention from national and international governing or regulating bodies occurs if they are determined to be heading towards collapse.

Using these criteria, the Financial Stability Board published a report in 2011 which listed the 29 global SIFIs that were expected to comply with their recommendations. The initial list compromised major international banks including HSBC, Goldman Sachs and the Bank of China.

More recently, the Financial Stability Oversight Council (FSOC) has been working on proposals to widen the range of institutions classed as G-SIFIs to include insurance firms, investment firms, and Financial Market Infrastructures (FMIs). There is currently a three stage process through which these non-bank SIFIs will be determined. A potential G-SIFI will be required to submit its business documentation and financial statements for analysis to determine:

if they have more than $50 million in consolidated assets;

how much the company being at risk would affect the economy at large (by looking at factors such as size and interconnectedness); and

how susceptible the company would be to hardship in an economic downturn (by assessing factors such as maturity mismatch).

Statuses are to be reconfirmed on a yearly basis, and expert analysis and scrutiny can result in an institution either being categorized as a global SIFI, or losing this title, regardless of whether those indicators discussed are found. These companies can also contest the decisions made.

How are they regulated?

Address the risks that SIFIs present became an issue at the forefront of the agenda at the G20 Summits following the financial crisis. At the 2010 Seoul Summit, various policy measures and the framework for their implementation, as recommended by the FSB, were endorsed by leaders. These measures required SIFIs to be supervised more effectively and ensuring that they have a greater loss absorption capacity (Financial Stability Board 2011). They are now expected to have “a higher share of their balance sheets funded by instruments [that] increase the resilience of the institution,” which is expected to reduce the likelihood of their failure (Basel 2011).

The ‘Key Attributes’ were agreed upon by leaders at the G20 in 2011 as guideline to which global SIFIs should adhere. These twelve attributes were seen by the FSB and global leaders as the necessary steps that the state would need to take should a G-SIFI begin showing signs of failure. Features recommended include ensuring that private source funding would be able to provide temporary financing to enable the institution to continue their critical operations in the event of a failure. The regime in question should also have resolution authority and power, for example the ability to transfer the critical functions of a failing firm to a third party. Global SIFIs are also expected to have Crisis Management Groups (CMGs), Cross Border Cooperation Agreements (COAGs) and disaster plans, known as living wills.

In return, the national authorities are required to prepare resolution plans so that the taxpayer is protected and the institution’s important functions are preserved or restored. Thus, several advisory councils aim to minimize the economic disruption that a financial crisis can cause through advocating regulation of systematically important institutions and these numerous measures have been embraced by international leaders at global summits. For example, reforming the International Financial Architecture through improving the surveillance and analysis of institutions, and ensuring that standards are proving effective, are key objectives of the Russian Presidency of the G20. G20 members have also been working to ensure that their national economies provide favorable conditions for the FSB to carry out its reforms.

Why regulate?

By recommending these minimum standards, the FSB has attempted to create greater political control of G-SIFIs and increase transparency within the financial system. Moreover, by recommending means to reduce the impact of a financial shock on critical banks, these resolutions also represent an effort to minimize the requirement for government bail outs. Avoiding intervention has many benefits for the party in power, since businesses and members of the public will be able to retain confidence in the markets. The taxpayer is better able to enjoy security, as banks are no longer able to take such great risks.

Financial contagion is also more likely to be avoided if resolution regimes are implemented, as they provide a framework for governments to quickly contain a financial shock. This will therefore reduce the possibility of a national economic issue spreading across borders, as the US subprime mortgage crisis and the European Sovereign Debt Crisis have done. Furthermore, reducing debt, improving the bank’s balance sheets, and improving the economy’s liquidity through regulation would also reduce the possibility of a run on the banks or a fire sale of assets (whereby shareholders sell them at extremely reduced prices). Thus, confidence in the financial system would remain, both on a domestic and international level.

In addition, the increased scrutiny of financial institutions will allow for recurring problems in economic practice and the reforms themselves to become clear. Increased attention on G-SIFI activity inevitability leads to greater compliance with financial regulation, as these institutions now have little choice but to behave more responsibly in order to keep their prestigious reputations, banking licenses, and to avoid incurring heavy fines. Hence, regulation of global SIFIs has clear political, economic and societal benefits, and consequently should be encouraged.

Progress made and successes of this regulation

In 2010, the United States congress introduced the Dodd Franks Consumer Protection Act. This legislation for Wall Street reform made significant changes to the regulation of the financial services industry in the US, and set out to “promote financial stability… by improving accountability and transparency in the financial system… [and] to protect consumers from abusive financial services practices” (111th Congress of the United States 2010). Factors including the introduction of a Consumer Protection Agency and an Oversight Council to assess the levels of systematic risk were introduced in order to achieve such aims. Meanwhile the EU have recently reached agreement on a “Banking Recovery and Resolution Directive” that is expected to be finalized by the end of 2013. It is hoped that the policies implemented will help reduce the likelihood of government bail outs, as authorities and banks become better prepared for instances of financial distress.

Furthermore, Crisis Management Groups have been set up for nearly all of the 29 institutions categorized as G-SIFIs in 2011, and as the FSB reported, senior level engagement ‘has proved critical in advancing recovery and resolution planning work’ within these CMGs (Financial Stability Board 2012). The new focus on the activities of non-bank institutions that are potentially systematically important allows “regulators to spot the buildup of risk in various pockets of the economic system that eluded them prior to the financial crisis.” (Nasiripour 2013).

Problems evident in attempts to regulate

The greatest issue with attempts to control the activities of global SIFIs is the absence of a global regulator and the lack of a policy framework that all important institutions are expected to abide by, regardless of their jurisdiction. At present, each entity is treated separately; consequently national governments are theoretically deemed responsible for dealing with financial shocks in their state and are expected to stop them from spreading across borders. However, as the repercussions of the failure of a G-SIFI would likely be felt on an international scale, ‘it is not uniquely a problem for national authorities’ and a ‘global minimum agreement’ would therefore be more suitable (Basel 2011). Sharing information across borders to aid supervision and analysis is complicated by factors including domestic privacy and censorship laws. Returning or transferring assets back to clients in times of economic uncertainty will be made more complex by the ‘respective national laws relating to way in which client assets are held and protected,’ and this could ‘give rise to legal disputes as to ownership and entitlement to the assets’ (Financial Stability Board 2012).

Additionally, as the regulation set out by these bodies is merely advisory, compliancy with the standards advocated has not been wholly achieved, and progress has been slow, as illustrated in Figure 1. For example, the EU directive, whose guidelines member states are waiting upon in order to finalize their own regulatory practices, is unlikely to be put into practice until 2014. Thus, areas that do not yet have a policy framework in place, such as resolution regimes for investment firms in the United Kingdom, are unlikely to be addressed in the foreseeable future.

Figure 1

Similarly, there has been much delay in the implementation of the Dodd Frank rules. As Figure 2 demonstrates, approximately two-thirds of the provisional deadlines for the finalization of terms unacceptable behavior for banks and other powerful financial bodies have been missed. The approaches of different regulators, combined with the “well funded opposition of the finance-industry lobby” and continuous legal matters have contributed heavily towards the lack of positive developments since the Act was announced (McCoy 2013). There is also moral hazard involved in designating any company “too big to fail,” as the more systematically important an institution is deemed to be, the greater the possibility that it will be rescued by the central bank or national government. This guarantee therefore leads to minimal market discipline, and is understandably described by Senator Harsiling as ‘bad policy, and even worse economics’ (Katz and Tracer 2013).

Figure 2

Lastly, as Patrick Slovik’s recent study has shown, tighter capital requirements (as imposed by regulation), have the potential to “increase the incentives of banks to bypass the regulatory framework,” or exploit it, by increasing their profitability through unconventional means (Slovik 2012). For this reason, regulation can also be seen to have “contributed to or even reinforced adverse systemic shocks that materialized during the financial crisis,” as the unconventional practices caused the institutions to lose focus of their core functions that became perceived as unprofitable (Slovik 2012).

Conclusion

The challenge for regulators has been to identify the roots of financial contagion and adopt resolution regimes in line with the ever-changing global financial network to prevent institutions from becoming exposed to economic shocks, thereby reducing the possibility of government led bail-outs. Despite slow progress, the global SIFI label will increasingly limit the risky practices of critical global firms as the rules become standardized: strengthening the financial system and increasing the security of taxpayer money in the process. Encouraging banks to practice their core economic functions and increasing market discipline if this does not occur will also be beneficial for financial stability.

Although, ‘no supervisory system can catch everything,’ it is important that G20 leaders can rely on bodies such as the FSB and Basel Committee to provide ‘intense, effective and reliable’ supervision of G-SIFIs (Financial Stability Board 2012). The expansion of the global SIFI category to include companies such as major insurance firms and pension funds is a positive step. But new regulators need to acknowledge their limited experience in these areas and ensure that they learn from, and work with, bodies which previously oversaw their practices, and that the terms being laid out are sector specific.

In the future, a truly global framework that covers multiple jurisdictions and ensures compliancy between nation states should be encouraged. International forums such as the G20 provide the perfect opportunity for leaders to begin working towards this goal.